STRIPS

A government bond is really a bundle of payments. A coupon every six months, and the face value returned at the end.

Stripping unties the bundle. Each payment becomes a security in its own right and trades on its own.

So one bond maturing in ten years becomes twenty small securities, one for each coupon, plus one for the principal. The workbook calls the last of these the principal STRIP and each of the others a coupon STRIP.

Every one of them is a zero coupon bond. It pays nothing along the way and one amount on one date.

That is exactly why they suit a retail investor. There is no coupon arriving that has to be put somewhere. So there is no risk of having to reinvest at a worse rate — no reinvestment risk at all.

Nothing new is issued when a bond is stripped. The government does not sell STRIPS. They are made out of bonds that already exist.

The definition (section 9.9). STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. STRIPS are essentially separate zero coupon bonds created by breaking down the cash flows of a regular G-Sec.

The workbook's own worked case. When Rs 100 of the 5.77% GS 2030 is stripped:

• the Rs 100 principal payment at maturity becomes a principal STRIP;
• each coupon cash flow of Rs 2.885 becomes a coupon STRIP;
• all of them can then be traded separately as independent securities in the secondary market.

The Rs 2.885 is not arbitrary. A dated G-Sec pays its coupon semi-annually, so the half-yearly payment on Rs 100 of a 5.77% security is 5.77 ÷ 2 = 2.885.

What can be stripped. STRIPS can be created out of all existing fixed coupon SLR eligible G-Secs. Three conditions in one phrase, and each one excludes something: the security must already exist, its coupon must be fixed (so a Floating Rate Bond cannot be stripped, because its future cash flows are not known), and it must be SLR eligible (so the special securities — oil, food, fertiliser and bank recapitalisation bonds — and Uday bonds are out, because the workbook says those are not eligible as SLR securities).

Why they suit retail investors. STRIPS can be attractive to retail and non-institutional investors because, being zero coupon bonds, they have zero reinvestment risk. A coupon-paying bond hands the investor cash every six months that has to be redeployed at whatever rate then prevails; a STRIP hands over one amount on one date, so the return is locked at purchase.

Where they sit. The workbook lists STRIPS among the instruments of the government debt market, alongside T-bills, dated securities, Floating Rate Bonds, Zero Coupon Bonds, Capital Indexed Bonds, Inflation Indexed Bonds, special securities, Sovereign Gold Bonds, Savings (Taxable) Bonds and State Government Securities. Chapter 9 also names G-secs, T-bills and SDLs together as one of the 3 key segments of India's debt market.

Take the workbook's own security, 5.77% GS 2030, and a client holding Rs 10,00,000 of face value.

Unstripped, it pays Rs 28,850 every six months — 2.885% of Rs 10,00,000 — and returns Rs 10,00,000 at maturity.

Stripped, that single holding becomes:

Now the use an adviser would actually make of it. Mrs Pillai needs Rs 28,850 for a school fee due in a particular month four years out. Buying the coupon STRIP that matures in that month delivers exactly that amount on exactly that date.

Compare the two routes to the same goal. Assume a 7% yield, used only to make the arithmetic run — the workbook gives no yield for this security.

If rates fall to 5% over those four years, the reinvested coupons compound more slowly and the bondholder ends up short of plan. The STRIP holder is unaffected, because there was never anything to reinvest. At 7% the STRIP would cost about Rs 22,000 today and pay Rs 28,850 in four years, with no further decision required.

That is the workbook's argument for STRIPS appealing to retail investors, stated as a rupee outcome rather than a principle. And it works only because STRIPS can be created out of all existing fixed coupon SLR eligible G-Secs — there is a deep enough pool of dates to match a real goal to.

Chapter 9 (Investing in Fixed Income Securities), section 9.9 (Introduction to Government Debt Market), where STRIPS appear between special securities and Sovereign Gold Bonds in the list of instruments. Expect a recall question on what the acronym expands to, one asking which G-Secs can be stripped — all existing fixed coupon SLR eligible ones — and one asking why STRIPS suit retail investors, where the answer is that they are zero coupon bonds and so carry zero reinvestment risk. The Rs 100 and Rs 2.885 split of 5.77% GS 2030 is the workbook's own illustration.

• STRIPS are not issued by the government. They are created by separating the cash flows of an existing G-Sec. An option describing a fresh issue of STRIPS is wrong.
• Only fixed coupon, SLR eligible, existing G-Secs can be stripped. All three conditions. A floating rate bond has unknown future cash flows; special securities and Uday bonds are not SLR eligible.
• Rs 2.885 is the half-yearly coupon on Rs 100 of a 5.77% security, because dated G-Secs pay semi-annually. Using Rs 5.77 per coupon is the standard slip.
• Zero reinvestment risk, not zero risk. A STRIP still carries interest rate risk, and its price moves further for a given yield change than a coupon bond of the same maturity because every rupee of it arrives at the end.
• One bond becomes many securities, not two. Each coupon date is its own STRIP, plus one principal STRIP.
• A coupon STRIP is not a coupon. It is a tradeable zero coupon security whose single cash flow happens to equal a coupon.
• STRIPS are a G-Sec mechanism in this workbook. Do not extend it to corporate bonds on the strength of general knowledge.